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    Cost of Capital

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    Mini Case,

    a. 1) What sources of capital should be included when you estimate Cox's weighted average cost of capital (WACC)?

    2) Should the component costs be figured on a before-tax or an after-tax basis?

    3) Should the costs be historical (embedded) coasts or new (marginal) cost?

    b. What is the market interest rate on Cox's debt and its component cost of debt"

    c. 1) What is the firm's cost of preferred stock?

    2) Cox's preferred stock is riskier to investors than its debt, yet the preferred's yield to investors is lower than the yield to maturity on the debt. Does this suggest that you have made a mistake? (Hint: Think about taxes)

    Please also use the attached Spreadsheet!

    During the last few years, Cox Technologies has been too constrained by the high cost of capital to make many
    capital investments. Recently, though, capital costs have been declining, and the company has decided to look
    seriously at a major expansion program that had been proposed by the marketing department. Assume that you
    are an assistant to Jerry Lee, the financial vice-president. Your first task is to estimate Cox's cost of capital.
    Lee has provided data that he believes is relevant to your task.
    (1) The firm's tax rate is 40%
    (2) The current price of Cox's 12 percent coupon, semiannual payment, noncallable bonds with 15 years remaining
    to maturity is $1,153.72. Cox does not use short-term interest-bearing debt on a permanent basis. New bonds
    would be privately placed with no flotation costs.
    (3) The current price of the firm's 10 percent, $100 par value, quarterly dividend, perpetual preferred stock is $113.10
    Cox would incur a flotation cost of $2.00 per share on a new issue.
    (4) Cox's common stock is currently selling at $50 per share. Its last dividend (Do) was $4.19, and dividends are
    expected to grow at a constant rate of 5% in the foreseeable future. Cox's beta is 1.2, the yield on T-bonds is
    7 percent, and the market risk premium is estimated to be 6 percent. For the bond-yield-risk-premium approach,
    the firm uses a 4 percentage point risk premium.
    (5) Cox's target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common
    equity.

    Sources of Capital
    Long-term debt
    Preferred Stock
    Common Equity

    The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses
    to finance its assets, or its WACC. There is an overall, or corporate, WACC which reflects the average riskiness
    of all the firm's assets. However, since different assets may have more or less risk than the average, the overall
    WACC must be adjusted up or down to reflect the riskiness of different proposed capital budgeting projects.

    Tax effects associated with financing either in capital budgeting cash flows or in costs of capital. Most firms
    incorporate tax effects in the cost of capital, therefore focus on after-tax costs. After-tax costs only effect the cost
    of debt. This is due to interest on debt being tax deductible.

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    Solution Preview

    a. 1) What sources of capital should be included when you estimate Cox's weighted average cost of capital (WACC)?

    In WACC only those sources are included which will take part in financing the investment. This will typically be long term debt, preferred stock and common stock. If a firm is using short term debt also for financing, then that also should be included. The sources of capital be included should be ones which are provided by the investors and have a cost attached to it. Non-interest bearing capital is not included. If some part of financing of working capital is by spontaneous liabilities ( non interest bearing), then these are not included, rather the gross working capital is converted to net working capital for the purpose of financing.

    2) Should the component costs be figured on a ...

    Solution Summary

    The solution explains what sources should be considered in the cost of capital and how to calculate the cost of each individual component.

    $2.19